Penny Hersher tries to analyze hedge fund ethics and how they affect regulation over on Huffington Post. There are a a couple things wrong with the assumptions that she makes, but I’ll wanted to discuss something that is taken for granted in this post.

Penny assumes that the hedge fund has a high water mark and is down 20% from their HWM. The options she give are:

a) stay with the fund until you have recouped the losses and made your investors whole – working for “psychic income” as Kenneth Griffin of Citadel fame told the New York Times or
b) leave – retire, switch to a new fund, start a few fund – basically start again? If you had many years of excellent performance before this one terrible year you may well be able to raise another fund.

The third option that I’m putting forth (just for the record, it’s a BAD option so don’t try it at home):

c) Increase Risk. Your basic hedge fund strategy (which you’ve documented in your offering documents and pitched to your investors) is a conservative low-risk strategy. If you are down several months and you see that using this conservative strategy isn’t going to work, there is the temptation to increase your risk tolerance to get you back above your hwm.

Increasing risk is very tempting as it is a short term solution which could potentially get you out of a bad slump. The downside is that if the increased risk causes increased losses the manager is likely to raise the risk again and dig themselves deeper. The fact that there were so many Madoff feeder funds was exactly because of this. A fund was struggling through the economic downturn, so to balance the losses they invested in a vehicle which under regular circumstances they would not invest in.

So, why do I bring this obviously bad “solution” up? Simply to make the point that while high water marks sound like a good thing for the investor, they can have catastrophic side effects.

If you’re down 20% and have a fund with a HWM, close the fund, start a new fund without a high water mark and get back to business.